Leveraged ETFs
On August 26th, 2022, the Nasdaq 100 index tumbled 4.1%.
Investors holding long ETFs seeking 1x of the index suffered a loss of about 4%, while those holding long ETFs seeking 3x of the index suffered more—a loss of about 12%.
On the other hand, investors holding short ETFs tracking the index earned a considerable profit, which could be 4%, or double or triple of 4%, depending on whether it’s leveraged or not.
What is a leveraged ETF?
Most people buy ETFs to invest in a market index.
While long and short non-leveraged ETFs seek 1x of the index performance, leveraged ETFs achieve 2 or 3 times the daily returns of an index by holding equities, as well as derivatives and debts.
This means every dollar you invested would generate a return equal to 2 or 3 times the daily returns of an index. On the other hand, you could lose 2 or 3 times the amount.
What to know before trading leveraged ETFs?
1. If the index goes up by 2% over a day, your 3x ETF will rise by about 6%.
When we invest in non-leveraged ETFs, we expect them to follow the movements of the index. When the index moves by 1% in a day, the ETF moves by 1%. When the index moves by 4% over a week, the ETF moves by 4%.
This is not the case with leveraged ETFs.
If an index increases by 1% in a day, you can expect an ETF seeking 3x of its returns to go up by about 3%. However, if an index increases by 2% over a week, the index will not necessarily climb up by 6%.
Similarly, if the index drops by 1% in a day, an ETF seeking 3x of its returns would go down by about 3%. However, if an index declines by 2% over a week, the ETF may drop by more or less than 6%.
2. If the index goes up by 5% over a month, your 3x ETF will not necessarily rise by about 15%.
Let’s look at some examples.
Both ETF 1 and ETF 2 track the Nasdaq 100 index (NDX). ETF 1 seeks a positive 1x of the index while ETF 2 seeks a positive 3x.
As we can see below, over the 6-month range, the performance of ETF 1 and NDX has overlapped, both showing a decline of about 7%.
On the other hand, over the 6 months, ETF 2 has declined by about 35%, almost 5 times the decline of NDX.
Let’s move to an example on short ETFs.
ETF 3 seeks an inverse 1x of NDX while ETF 4 seeks an inverse 3x.
Over the 10-M range, the index tumbled about 27%. Correspondingly, ETF 3 climbed up by 27%. ETF 4, on the other hand, went up by 65%, only 2.4 times the decline of NDX.
3. Leveraged ETFs amplify both profits and losses.
You may achieve larger profits by buying leveraged ETFs. However, as leveraged ETFs use debts and derivatives to achieve leverage, the expense ratios are higher compared with non-leveraged ETFs. More importantly, when the market turns against you, you can suffer more significant losses.
4. Leveraged ETFs are typically more expensive to hold overnight.
The NAV of leveraged ETF is calculated at the end of each trading day, with expense ratio, and transaction and financial costs generated in its portfolio deducted. If you hold leveraged ETFs overnight, the value of your shares would likely decrease on the next trading day. The longer you hold, the more costs you pay (deducted directly in NAV).
Bottom Line
Leveraged ETFs may not be suitable for all investments. Make sure you research the leveraged ETF before you invest. They can potentially provide higher returns and larger losses compared to non-leveraged ETFs.
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